Wednesday, February 09, 2011

Indonesian Central Bank Attempts to Manage Inflation


This week Indonesia raised interest rates for the first time in more than two years and is expected to raise rates again soon in an attempt to manage inflation. Consumer prices in Indonesia have risen more than 7 percent in the past year and the Indonesian government forecasts inflation rates of 4 to 6 percent this year. The Indonesian Central Bank hopes to signal to global investors that it is credibly responding to inflation that has continued to accelerate faster than expected. The government has blamed volatile food prices and an increase in global commodity costs like oil for the inflation.

A central bank’s strategy of raising interest rates to fight inflation poses its own dangers. If it raises interest rates too quickly, short-term speculation may flood into the country. This investment may then suddenly leave if economic conditions worsen or if other markets become more attractive. Indonesia has been successful in attracting international capital in recent years. Since the start of 2010, global investors have purchased more than $9.5 billion in Indonesian government bonds. However, when the government announced higher-than-expected inflation numbers, investors sold off more than $1 billion of the government bonds. This ebb and flow of investment complicates the work of monetary authorities and policymakers.

Indonesia’s concern with short-term inflows has prompted it to adopt alternative measures to fight inflation. First, the government has discouraged short-term speculation by imposing a one-month holding period on central bank certificates. Second, the Indonesian Central Bank has ordered lenders to set aside 5 percent of their total foreign-exchange holdings as reserves. Finally, the government has voluntarily lowered import tariffs on many agricultural products to curb rising food prices that have contributed to nearly half of the country's inflation.

Indonesia is just the latest of many countries to struggle with inflation. Other emerging markets have experienced inflation fueled by rapid domestic growth and rising international commodity prices. Indonesia's Southeast Asian peers of Thailand, Vietnam, and Cambodia have all announced interest rate increases this year.

Discussion Questions:
1. Should countries adopt capital controls to limit the effects of sudden capital inflows and outflows, or should they allow the market to function without investment constraints? What are the pros and cons of these approaches?
2. If most countries are experiencing inflation linked to food and oil price increases, why were global investors spooked into selling off Indonesian government bonds? What factors may have triggered investors to sell off in Indonesia, but not in other countries?

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